Question

Firm XYZ is considering a project to built a new facility to install a new production line. The firm requires a minimum return of 10% in this project, due to the risks involved. The firm is a 34% tax bracket. Sales, revenues and costs details are given in the table below:

Cost of new plant and equipment	$9,700,000
Shipping and installations costs	$300,000
Unit Sales forecasted                                              Year 1 50,000           Year 2 100,000           Year 3 100,000         Year 4 70,000         Year 5 50,000
Sales price per unit sold	$145
Variable costs per unit produced	$80
Annual fixed costs	$500,000
Net Working Capital requirements	An initial $100,000 will be needed to start production. After that, net working capital requirements until year 5 will be equal to 5% of the total sales for the year. No NWC will be recuperated at the end of year 5
Depreciation	Using the straight-line method, the depreciation expense is $2,000,000 per year during the five years of the project life.

Estimate the CCFA for the next 5 years of operation

Using the NPV and IRR decision methods, decide if the firm should take the project

Answer 1

hurdle rate	10%
tax	34%
sale per unit	145
variable per unit	80
annual fixed	500000
depr	2000000

cost	-9700000
shipping	-300000
initial	-100000

		y0	y1	y2	y3	y4	y5
	units		50000	100000	100000	70000	50000
1	Sales revenue		7250000	14500000	14500000	10150000	7250000
2	Operating costs		4500000	8500000	8500000	6100000	4500000
3	Depreciation		2000000	2000000	2000000	2000000	2000000
4	Income before tax		750000	4000000	4000000	2050000	750000
	[1-(2+3)]
5	Taxes at 34%	0	255000	1360000	1360000	697000	255000
6	Net income	0	495000	2640000	2640000	1353000	495000
	[4-5]
7	Cash flow from operation	0	2495000	4640000	4640000	3353000	2495000
	[1-2-5]
8	Initial Investment	-10100000
9	Changes in net working capital	0	362500	725000	725000	507500	0
10	Total cash flow from investment	-10100000	362500	725000	725000	507500	0
	[8+9]
11	Total cash flow	-10100000	2857500	5365000	5365000	3860500	2495000
	[7+10]

Now, NPV is net present value of all these cash flows. Let's take cost of capital to e equal to 10% hurdle rate acceptable to the company.

Then NPV = C0+C1/(1+r%)+C2/(1+r%)^2+...

Or use excel formula =NPV(10%,[cells containing final cash flows])

NPV=5148387.62

IRR is the internal rate of return which is calculated from the above NPV equation where NPV=0 but we find the 'r'.

Excel or BA Plus calculator can calculate precise value of IRR. IRR is 28.65%.

As IRR is greater than hurdle rate of 10%, the company should approve this project.

Also, as NPV is positive, hence by NPV also, this project is acceptable to the company.